Sunday, July 5, 2015

Watching Investment Paint Dry


For many mutual fund investors owning domestic stock and bond funds, the first half of 2015 while volatile on a week to week basis, for the six months performance was as exciting as watching paint dry. For these investors the net result was minor gains or losses in an essentially flat period. (We will discuss the positive results for international investments below.)

Different Speeds Create the Gap

Ever since the bottom of the last economic cycle, the domestic stock and bond markets have been producing worthwhile capital appreciation. The markets have been so much better than the economy that a valuation gap may have been created. One can say that some or the entire gap was formed by the combination with the Federal Reserve’s manipulated-low interest policy that there were insufficient returns in savings vehicles, thus money went into investing. At the very same time the main vehicles for investing in stocks have been shrinking. The combination of buy-backs and cash paid for mergers has reduced the number of shares available. The net result is that we have had a shortage of satisfactory investment vehicles. Shortages are cured by either new supply, higher prices, or both. Valuations rose in the face of shortages of investments at reasonable prices in spite of only pedestrian growth.

Closing the Gap

Often when a valuation gap appears it leads to a price correction. As noted by many, we have not had a domestic market correction which is normally translated as a 10% drop since the 2009 bottom.  There is a second way the gap can close, which is that over time the earnings production grows within a flat price environment. In addition to a sharp increase of new equity underwritings including IPOs, supply is increasing. Thus the gap is structurally closing.  Perhaps, flat is good for awhile.

Double Digit International Returns

As this post is being written the final performance returns for funds during the first half are not yet available. Nevertheless, I do have fund performance data through June 25th which shows a substantial number of International funds producing double digit returns. The best returns were coming from China and Japan. Undoubtedly some of the gains were given back since then, particularly for domestic Chinese portfolios.

This phenomenon has been understood by mutual fund investors who have been adding to their non-domestic holdings practically every week this year while redeeming their domestic stock funds. Is this just performance chasing?  All too often this is a practice of unsophisticated investors in a bull market which is often labeled momentum investing. Only a few can execute a withdrawal from momentum investing successfully.

Another Possible Explanation

We have seen a similar pattern in just about every mutual fund arena around the world. More and more people globally have noticed that their governments and central banks are in effect devaluing their local purchasing powers. While this pattern is global in nature, for many investors it is wise to invest some of their wealth, perhaps 25-50% beyond their home countries, as a form of diversification. In the case of US investors, there are some relatively bargain priced securities available outside of the US. If this trend becomes too strong it could be another example of the smart locals offloading their own securities onto the gullible foreigners, so caution is urged.

Implications of the Greek Vote

Now that the population of Greece has voted “No,” there is an improved chance that the euro will last longer than had the vote been reversed. There are increased odds that agreements having to do with the level of deficits will be kept. Thus those that remain within a smaller central currency will have a stronger currency to deal with the dollar and yuan.

The Meaning of Fund Redemptions

With every purchase of mutual fund shares, redemption is set up. What is purchased must be sold eventually to capture the full value of the investment. Historically it is a mistake to view gross redemptions as a sign of dissatisfaction. Post-redemption surveys indicate that for the most part investors are cashing out of various funds which have met their needs. Investors need the money for retirement or other needs where aggressive investing may be unsuitable.  Sometimes they switch to lower volatile funds to meet their new needs.

Most fund sales people and many investors focus on relatively near‑term past performance. They do not wish to buy into past poor performance, ignoring the principle of buying low and selling high. Thus there is relatively little in the way of fund purchases to meet normal, often actuarial based, redemptions. We are currently seeing this pattern increasing in importance due to changes in market structures, particularly by relatively inexperienced investors.

Unprofitable Investors’ Mechanistic Solutions

Frequently it has been said that mutual funds and some other investments are not bought, but are sold. The reason behind this statement is that investing is complex and difficult to do well. Earlier I alluded to momentum investing which is essentially jumping on a speeding train. The basic view is that gains of yesterday will be repeated tomorrow ad infinitum.  If this always works, almost any upward sloping mechanical strategy would work. Many are available through the wonders of the Internet world.

Increasingly, fees and commissions for investment products and services are controlled by regulatory bodies. In their minds, by definition, lower fees are better than higher fees without regard to quality of service and lifetime support. This view has led to little to no upfront charges and various ingenious ways to generate other revenues for the distribution and management entities. Thus, the number of full time mutual fund salespeople making a living providing services to investors has declined. Some of their efforts have been redirected to other packaged products, including unregistered offerings. Thus, with the number of peddlers down, the sales of open-end funds is not what it used to be.

There is some Help

Today’s younger investors are not facing their investment future alone.  Many of them are employees of companies, government bodies, schools and universities that offer salary reduction programs to supplement or replace defined benefit pension plans. As an investment advisor to some of these, where appropriate, I created a series of portfolios of funds. When I began with these I was concerned that the employees would pick out one of the better performing funds in the mix for their own after-tax account. To counteract such an undiversified approach, I captioned our reports with a cautionary label that individual funds used in the plans were not necessarily a good personal investment, or similar words. 

Even though one of the plans that we were the advisor to was judged to be the best large 401(k) plan for the past two years in a row, I saw no large scale use of the particular funds in the plan in the personal accounts, except by some of the people administering the plan. Evidently the high income participants separated their retirement money from their personal, and I presume more aggressive money. Thus in this case they did achieve reasonable diversification which should help them in the long run. In industry statistics the 401(k) and similar plans are considered institutions because of how they are sold, serviced, and priced, even though their ultimate beneficiaries are individual people who, over time, would have their own redemption patterns.

Question of the Week:
When you close out an investment, do you enter a similar investment or readjust your portfolio with the proceeds?
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A. Michael Lipper, C.F.A.,
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Sunday, June 28, 2015

Do Minor Price Changes Lead to Major Moves?

The Risk that Greece Will Not Leave the Euro

While much of the world worried about “Grexit” and its impact on the world’s economies and markets, much larger risks loom if the central banks continue to ignore the fundamentals, allowing governments in stress to thumb their noses at the laws of supply and demand and other realities faced by the rest of the world. My historical reaction is that if Greece remains in the Eurozone, it may mean the “Fall of France” eventually out of the Euro along with a couple of others that consistently run large deficits that threaten the value of the central currency. One could envision with France and possibly others out of the Euro, it will look like the old Hanseatic League. Led by German Baltic ports and allied with England, the Hanseatic League dominated free trade in northern Europe for the years between the late Middle Ages and the 1700’s.

Factors Behind Declining Interest Rates

Interest rates being quoted on US Money Market Deposit Accounts (MMDA) declined to a low of 0.31% and a weekend rate of 0.34% vs. 0.36% a week ago. Could this be that a number of banks don’t want to show “excess” deposits on June 30th reports? Perhaps these rates are dropping  because some banks do not want to have too much in the way of excess deposits as they might be of interest to an unwanted acquirer. Or is there a recent drop-off in the demand for short-term loans, as the average short/intermediate US Government & Treasury mutual fund dropped ‑0.14% for the week when the average general domestic taxable fixed income fund was flat on the week? The only major fixed income fund category to gain was the High Yield funds +0.11%.

Equity Funds Show Divergent Trends

The only domestic funds that showed gains in the week ending June 25th were Financial Services +0.09% and Health/Biotech +0.07% among the majors, plus Dedicated Short Bias funds +1.41% and Alternative Equity Market Neutral funds +0.14%. All the other domestic equity funds showed declines as somewhat predicted by the continued net redemptions of domestic equity funds. In contrast, every global and international fund posted gains for the week led by the average Indian fund rising in US dollar terms +2.36%.  In spite of the attention to the Greek stand off, international markets in local currency terms showed gains for the week of +3.9% for the Nikkei 225 and +3.36% for the Xetra DAX.  

While this was happening the internal Chinese market was crashing and had entered at least a correction (­­‑10%) or a bear market after a one year bull market gain in excess of +100%. Morgan Stanley is publicly telling its clients not to buy into this particular dip. Early Monday morning prices are down in Asia reacting perhaps to Greece. But more likely it is the need of the Chinese authorities to liberalize bank reserves and lower interest rates to stop the slide in their stock market. Some have even suggested restricting buying on margin. As a reaction to these moves on Sunday night in the US, the DJIA futures are being quoted off some 260 points.    

To some degree what didn’t happen was the most interesting occurrence of the week. Friday was the day when the annual reconstruction of the Russell indices took place with the DJIA going up marginally, the broader S&P 500 and the NASDAQ declining marginally.

Apparent Conservative Funds may be Risky

For the last seven weeks the oldest form of mutual fund,  the Balanced fund has seen net additions, with $1.6 Billion net coming in for the week alone. Is this just a sign of confusion as to direction or conservatism? Possibly the rise is due to 401k and similar defined contribution plans for employees being treated as mixed asset funds (bonds and stocks) which are somewhat more modern Balanced funds. If that is the case I hope that fiduciaries supervising these accounts have sufficient memory and education to recognize the risks of underperformance of mixed asset portfolios in sharply rising and falling markets. The Investment Company Institute, the fund business’s trade association, indicated that there were $741 Billion in retirement target date funds and another $400 Billion in somewhat similar “lifestyle” funds at the end of the first quarter. Under the correct personal conditions and understandings these vehicles might prove to be satisfactory; for others they may in the future prove to be problematic as these funds will own fixed income securities which may not perform well (as discussed below).

Fixed Income Risks

John Authers of the Financial Times had a very thought provoking column on Thursday exploring the “Bondification” movement to address the fundamental concerns that have led bond fund managements to under-perform. Most bond investors start with the assumption of a “risk free” interest rate based on local country Treasury yields. The problem is that with various bouts of qualitative easing as managed by many central banks, these interest rates have proven to be quite volatile. In my opinion, the restructuring of bond markets in a period of diminished capital on trading desks makes bonds anything but stable. The bond professionals have responded by developing a culture of unconstrained fixed income portfolios that allow managers ultimate flexibility in terms of maturity, credit quality and inclusions of derivatives and in some cases commodities. While this flexibility can, if well executed, produce good relative results, they bring into question how bonds should be used to provide some risk-dampening to a mixed asset portfolio. I hope the owners of target date funds and lifestyle funds understand these changes from past performance records.

Liquidity Concerns

Exchange Traded Funds (ETFs) have become an important institutional trading device; the US Securities & Exchange Commission (SEC) is showing concerns as to the use of derivatives both within ETFs and their marketing partners. For the most part institutions and individuals buy and sell ETFs through market makers called Authorized Participants (APs). When a buyer or seller of an ETF operates through the limited number of APs, they are utilizing the liquidity of the AP for each ETF. Some of this liquidity is in the form of derivatives. The SEC and other analysts would like to understand the size and nature of the liquidity that exists for specific ETFs. My particular concern is primarily based on sector and some single country vehicles. We will see whether the SEC will get the details on a timely basis and make them publicly available.

The use of public disclosure of how various funds manage their portfolios can add some reassurance. For example, the National Economic Research Association (NERA) has published a white paper examining if a fund broke any of the constraints being applied to Money Market funds. Among their findings was a theoretical conclusion that at worst there may be a temporary 1-3% break from the dollar NAV with most of that happening in the first two days followed by a recovery likely by the end of the first ten days. I hope that they are correct as I have regularly used Money Market funds to hold required firm capital.

Outliving Retirement Capital

Many people are  living longer. As a group, they have not changed their spending and savings habits. Also, governments have not fully recognized these implications. Both the workplace and retail distributors are behind in adjusting to this reality.

GDP for the first quarter in the US was revised to a decline of only 0.2% from 0.7% as originally reported. As previously pointed out in these posts the change was not a surprise. In this case the markets were a better forecaster than government agencies. The size of the adjustment is too large for those who steer our ship of state to put reliance on their own statistical collection approaches.

Question of the Week:  Based upon the week’s news, do you remain a Bull or a Bear?
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A. Michael Lipper, C.F.A.,
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Sunday, June 21, 2015

Future Father’s Day Fears

In the US, commercial interests have created a day to celebrate Fathers. For me, Father’s Day has been a day of getting together with parts of my nuclear family. Some are from great distances including Singapore. Close friends that feel a family-like cohesion with my wife Ruth and I phone in or send cards. At the moment, all appear to be well and progressing with their lives. While I am enjoying all this goodwill among our extended family, my first fear is that it can’t last.

Uncertain future

The future is and always has been uncertain, it seems particularly uncertain now. While as a human and an investor, I can handle that; what I find unnerving is that far too few people are planning to handle future problems which include opportunities. Today, there are two elements to my concern - terminal values and flight capital.

Terminal values

The purpose of not spending all of our current income and capital is to provide for future spending. As both a Father, Grandfather and surprising at least to me, Great-Grandfather, as well as a trustee for a number of organizations that are chartered for perpetuity, I should be thinking about the ending piles of dollars and other currencies to meet future needs. While it is true that this is not a unique concern of mine, notice that most all of the focus of the investment world is the present relative price of assets and liabilities. Regularly we are told that an asset is attractive because the current price on a relative basis is cheaper than other assets. There is a presumption that the particular price will rise and fill the gap compared with other assets. In my US Marine Corps days I would label that as a tactical movement. Tactics are important in the battle for investment survival, but rarely accomplish the strategic mission of winning the war and creating a lasting peace.

The first major fear

This week’s piece from John Mauldin is about the large and growing underfunding of state and large city pensions. Various governments, both in the US and elsewhere (Greece and most other countries), appear not willing to close this retirement funding gap. There are two issues with this incipient failure to keep the promises made to both government employees and their supporting tax payers. First is that future contracts to deliver pensions appears to be based on what is now clearly false assumptions as to rates of investment returns and the willingness of politicians to get taxpayers to close the funding gap. This present dilemma has three probable impacts on me and our investments that could be beyond our current plans:

a.  Our tax burden will go up.
b. The services we expect from government will decline.
c.  New money that must be invested will likely push markets higher.

I started this discussion about the lack of focus on the terminal value of investments, which I find to be disappointing. However, the discussion above about the pension gap is a clear example of an attempt to project terminal values. Many, but not all private organizations also have granted their employees pensions, and appear to be able to meet their obligations to the older employees and retirees. (Some have reduced their exposures by Pension Risk Transfer contracting with Prudential and other insurance companies.) The larger approach is to put as many of the employees into defined contribution plans; e.g., 401k or similar plans. In these plans normally both the employer and the employee contribute to the plans and have a number of choices of investments products available to select. The employee is at risk to choose the vehicles that will produce the best return based on personal and investment factors. Some will choose well and others won’t. In most plans the choices are institutional grade mutual funds. We can testify that in one case, The Second Career Savings Plan of the National Football League and the NFL Players Association that it has worked out. For the last two calendar years BrightScope has found this plan to be the Number One of large 401k plans. While the criteria for that ranking does not directly include investment performance, without reasonably good investment results for the players the plan would not have grown as it did with Lipper Advisory Services as its investment advisor.

Nevertheless, the individual players and their families are at risk as to the uncertain value of their terminal accounts. I have the very same problem when I invest for my family’s future. I can not honestly say what will be the ending value of their investment accounts. What I can do in my selection of mutual funds and individual securities is in my own mind to focus my selection based on what I believe are likely future values, at least on a relative basis. I believe that more of us professional investors should be focusing on expected terminal values.

Second major fear

This week is the twentieth straight week with net redemptions in equity funds. When looking at the underlying details, the redemptions are largely in domestically-oriented funds which are importantly offset by purchases of International funds. I find a similar pattern in most countries with the main exception of China. When people switch out of their local currency into other currencies it is traditionally a sign of expected trouble in a country. Are they doing this now through their International fund purchases? They may be seeing higher terminal values beyond their borders. As this is a global pattern, one might say the money class of investors is hedging its bets.

Question of the week:
What are your longer term fears?
Did you miss my blog last week?  Click here to read.

Comment or email me a question to .

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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.